Securitization matures, gains status on way to magic $100 billion

Industry experts say it won't be long before the real estate securitization market reaches $100 billion. Yet already it has taken its place the more extablished funding vehicles.

Traditional lenders may be back, but the commercial mortgage, backed securities (CMBS) market is approaching the $100 billion mark, growing up and becoming a more efficient market in the face of increasing competition.

Conduits have taken the place of the RTC - and many mortgage bankers. While conduits may continue to see a winnowing out of participants, their transaction volume is expected to increase dramatically this year. The number of investors buying CMBS is also on the upswing. Of course so is the lending activity of life insurance companies across the country. But CMBS is holding and even increasing its ground, offering borrowers a more standardized and economical lending mechanism to access the nation's capital markets that insurers are even emulating.

Wall Street investment banks, conduit originators and rating agencies all express optimism about the maturation and expansion of the industry. Many expect total issuance in 1996 to increase to approximately $20 billion.

"Clearly, we think the market as improved," says Michael Spoor, president of Houston-based Banc One Commercial Loan Origination Corp., a subsidiary to my counterparts, we're all expecting to have a good year."

On the equity side, real estate investment trusts (REITs) show similarity to conduits in being a young growth industry that is getting stronger, despite some consolidations of smaller, older struggling REITs to create better capitalized entities. While new REIT offerings have slowed, the $60 billion industry still attracts a wider array of large and small investors who see long-term viability and growth potential in a recapitalized real estate industry that increasingly resembles other publicly traded industries - valued more on its management and operations than on individual properties and transactions.

The total return for equity REITs in 1995 was 15.27%, pulled down by the retail sector. While REIT gains did not outpace last year's broader bull market, REITs show signs of a commendably competitive long-term performance level, which Nomura Securities International Inc., compares to the tortoise in its race with the hare - slow and steady, but a winner.

CMBS issuance expected to rise

New CMBS issues totaled $18.9 billion in 1995, down 6% from 1994, according to Nomura. David P. Jacob, managing director and director of research and securitization at Nomura, says, "A good portion of the decline had to do with the run-up in rates at the end of 1994, which curtailed refinancing activity. A secondary factor was the continued decline of RTC issuance, which closed its doors at the end of 1995, after selling or closing 747 thrift institutions with assets of $452 billion.

Conduits are expected to generate at least $5.5 billion of this year's expected $20 billion of issuance, according to Jonathan Adams, vice president in the mortgage research group at Prudential Securities Inc. That level is up from $1.2 billion in 1993 and $4.5 billion in 1995.

While conduit volume is rising, the number of conduit originators has decreased from the frenzied pace of entry just a few years ago. "Conduit envy is well over now," says Joe Franzetti, senior vice president at Duff & Phelps Credit Rating Co. He mentions that many conduit-wannabes who had limited participation in the market have fallen by the wayside, unable to offer up the loan warehousing and placement capabilities necessary for such an operation. "Inefficiencies were rife, but no many people have dropped out of the business that didn't belong there to begin with," Franzetti says.

Those who remain - investment and commercial banks, among others - increasingly compete with life insurance companies and each other.

A common ingredient for most of the surviving conduit issuers is that they have a stake in their pools rather than simply collect fees and then disappear from the process, says E. J. Burke, program director of Midland Loan Services, L.P., Kansas City, who says he expects this trend to continue. "The market recognizes that you will have better quality from those with their own money at risk."

Unlike conduits, Chemical Commercial Mortgage Banking Corp. commits its own money in the deals it is involved with, so when borrowers deal with Chemical Commercial, they are dealing with the actual money source, says Jacqueline Slater, head of the securitization department.

As for the CMBS market, says Slater: "Its definitely growing very fast. It's bringing liquidity to the real estate market that wasn't there before. It allows more access to greater and greater pools of cash."

Insurers leaning toward securitization

"Life companies are beginning to understand how much it costs for them to originate and service whole loans and hold them on their balance sheet," says Burke. "They are also getting presure to dispose and find liquidity, but not at a loss. A number of them are cooking at originating loans on terms nd pricing very similar to what conduits are doing. Obviously, as both of ur standards converge, the most efficient producer will get the greater mart share."

Overall, insurance companies have to decide the benefits of CMBS vs. whole loans, Franzetti says. "They are coming to appreciate that securitization reduces their cost to acquire and produces more liquidity and better capital treatment by regulators."

Banc One's Spoor does see the agressive life companies getting back into he market. "I think time will tell how ig an appetite the life companies ave," he says.

Jacob says Nomura expects to see insurance companies continue to securitize their loans and retain BBB-rated bonds, especially since the NAIC (National Association of Insurance Commissioners) approval of securitization in May 1995. While insurance company activity in CMBS may increase, some banks may shy away from securitization in favor of whole loans, Jacob says, because of recently proposed OCC regulations, which contain "a very stiff diversification text, which effectively nullifies the effect of the 1994 bill (which Congress passed) for CMBS." The key provision allows national banks to invest only in deals where the concentration limit on a single borrower in a pool of securitized loans does not exceed 5%.

"Conduits or small loan securitizations could meet the 5% concentration limit. However, some CMBS deals could not, because they consist of a limited number of borrowers with large pools of properties and loans that are often cross collateralized and cross defaulted. By focusing solely on the number of borrowers, the regulations miss many important structural provisions which materially improve the quality of the securities," Nomura reports.

"The OCC will probably recognize that it does not make sense to put forward a regulation that counteracts 75% of the action of Congress and will want to hear what market participants have to say about it and will respond accordingly," Adams says.

Conduits have product ready

"Many conduits have loans in the pipeline, which is a pretty good base for the market to stand on. A favorable interest rate environment and a good deal of loan origination should bode well for conduit activity in particular," Adams says.

"Conduit programs are hitting their stride. We expect to see a number of repeat issuers from those who were established last year," Franzetti says.

Much of the increased conduit production expected this year will come from Wall Street. "There are probably six or seven particularly active conduit issuers," Adams says. "We have as a target $600 million for 1996 in new issuance, compared to just over $300 million in 1995. Merrill Lynch and Lehman Brothers have similar projections as well."

Some noteworthy deals have already been completed. In December 1995, Atlanta-based Column Financial, Inc., the conduit arm of Equitable Real Estate Investment Management Inc. and Donaldson, Lufkin & Jenrette (DLJ), completed a $508.5 million securitization backed by 166 commercial mortgage loans. Adam Raboy, who heads conduit operations at DLJ, says he expects total DLJ conduit pro uction to increase approximately 20% from last year to around $1.2 billion in 1996. Lehman Brothers is managing, for Toronto-based Confederation Life Insurance, the securitization of a $1.9 billion loan portfolio, which is reported to be the largest CMBS deal ever; it was expected to hit the market in late February. The transaction consists of approximately 575 fixed-rate performing mortgages primarily backed by multifamily, retail and office properties.

Offerings are larger, more uniform

The Confederation Life deal typifies the trend toward bigger deals in CMBS, largely due to economies of scale. According to Nomura, the average deal size in 1995 was approximately $193 million, up from $165 million in 1994.

Adams says he expects deal size "to creep up a bit, especially in conduits," largely because it makes no economic sense to go through the expensive rating and due diligence processes for small pools. He says he expects deals to range between $200 and $450 million. However, It at some point, the amount of necessary due diligence makes you pause and perhaps not do it or rule out certain classes of debt, such as subordinate, which require the most due diligence. There is a ceiling in which incresing the size of a pool does not help."

Deals are not only getting bigger, they are also becoming more standardized. Franzetti says Duff & Phelps is seeing more deals that look alike, with more uniformity in terms of structure and collateral. "It means CMBS has arrived at a point similar to its residential brethren," he says. "Such consistency makes the process more efficient and provides cheaper capital."

Maturation of the CMBS process is evident in a more streamlined dissemination of information to investors, better reporting from servicers, additional information requirements from borrowers regarding deal structures and better performance monitoring by rating agencies. Conduits are also becoming more systematic in establishing a kind of uniform call protection that has been an inherent part of residential mortgage-backed securities and insurance company lending practices for years. "Conduits used to negotiate it away to give the lender an extra Adams says, but as that practice diminishes, CMBS becomes much more similar to corporate debt. "If an investor is comfortable with the credit, the extra spread you would demand for being exposed to pre-payment is not necessary."

All of these efficiency factors combine to tighten spreads and make CMBS more competitive with whole loan offerings of insurance companies.

"Insurers are fully back in the market and are bidding aggressively for what they see as large, attractive mortgages on stable properties," Adams says. "As that occurs and as the selection of such properties diminishes, the most attractive alternative is A or BBB CMBS with some incremental spread on that investment-grade product.

"Even if the economy were to weaken, (spreads) would not widen tremendously, unless there was a severe recession," Adams says.

Nomura reports that CMBS spreads did not tighten in 1995 as they did in 1994. "In our view, they will resume the tightening trend in 1996 as investors look back at the performance of CMBS for the last several years. In particular, CMBS substantially outperformed corporate bonds even in 1995, where spreads were largely unchanged."

Franzetti says the additional capital chasing real estate and a strengthening secondary market should both cause spreads to tighten somewhat. "People know there is an exit strategy, so that means tighter spreads."

Todd Schuster, president of Continental Wingate Financial Services, Boston, says spreads could get extremely tight for loans on multifamily and industrial properties, "the darling products" of insurance companies, whose nervousness about the retail properties will cause them to step back and "only pursue the highest quality product" in a possibly troubled sector.

Retail health in question

Numerous downgrades of CMBS in the final quarter of 1995 were "attributable to the deterioration of Kmart and the general weakness in the retail sector" and were limited to deals where the credit rating was based on the tenant, according to Nomura. "Other deals with large retail components were most unaffected," Jacob says.

"If you look at the delinquency rates of the last eight years, retail is the best performer, even better than multifamilies," Adams says, admitting that the retail sector is undergoing a cyclical decline coinciding with the downgrading of individual retailers. However, he points out that it is often foolish to compare retail property with a retailer's credit and that much of the current concern about retail property performance is probably misplaced.

"We don't expect a tremendous upswing in delinquency rates for retail stores, even though we are in a retail downswing that will undoubtedly bring a consolidation in discount and apparel retailers. But that does not necessarily translate that property owners will experience the same kind of distress as individual retailers, as many of these properties are easily re-leased. Kmart can be replaced by a food store or some other retailer like Home Depot or Staples that shows good health," Adams says.

"We don't see retail suddenly disappearing in the make-up of pools. Regional malls with a diverse tenant base are sound, and that tier of the sector shows no overbuilding." He says that the same is true of super regionals, small well-anchored community centers and neighborhood strip malls. "You will see differing performance property by property, but we don't think distress in retail will be widespread. It can be isolated in a pool of loans, and the potential for default can be seen and overcome," he says. "Retail performance will surprise people in a year to 18 months from now. Even under some pressure and with some isolated incidents of default, it will perform well."

Franzetti agrees that any retail problems are local-market sensitive and have to be studied on a case-by-case basis. "There have been some problem transactions, but not an overwhelming number. Everyone is concerned with retail; it seems to be the flavor of the day."

Jeffrey A. Tischler, senior vice president and CFO of Philadelphia, Pa.- based based Commonwealth Land Title Insurance Co. and its affiliate, Transnation Title insurance Co., points out that in retail, most of the activity is in the merging of the REITs. However, he notes that traditional lenders are back, and with interest rates remaining stable, the industry will see recovery. "Stability among consumers and stability in the economy will lead to more stable retail REITs."

Nomura's Jacob explains that investors' "love affair" with retail "has provided the support for a glut of financing at unrealistic rates." Therefore the "early recovery" phase that other property sectors are undergoing is denied retail, "where big box new construction has pushed total new supply up to the 1980s high water mark at a time when apparel sales are showing distinct signs of weaker long-term trends."

He contrasts the retail situation with the hotel sector, whose "favorable early recovery episode has been dramatically extended by investors' aversion to these properties. Hotels' strong performance four years in a row is directly linked to being the sector many `love to hate.' When investors `fall in love' with a market, it's never good for the market."

Pools are more diversified

While Nomura and others see improvement in the quality of the underlying real estate collateral that comprises CMBS pools, Franzetti says that "because of all the conduit competition, the collateral has slipped slowly to some degree."

In many cases, conduit loan production is for older properties with stories attached to them, Burke says. "It looks like thrift loan production did years ago. But rating agencies will tell you that the underwriting is substantially better," he says, adding that a key to Midland's success is to have properties that are well margined with adequate cash-flow and borrower equity. "When life companies are giving quotes that are 75 to 100 basis points tighter, it is harder to get better quality properties, he adds.

Franzetti admits that those who are pooling assets are achieving better diversification in all areas - by borrower, geography and property type. "We are seeing better pools, but not necessarily better underlying properties," he says, adding that typically properties being securitized are those that traditional lenders do not want. Hotels, health care facilities and office buildings are seeing more securitization interest largely because traditional lenders are still skittish about them. But Schuster says that as the hotel and office markets firm up, he expects to see life companies get more aggressive in lending to them.

While multifamily and retail properties continue to be the favorites of CMBS pools, offices and hotels became significantly more attractive in 1995, Adams says, adding that he sees a limit to how much the hotel sector will contribute to CMBS in part because that they do not comprise that much of the total property value in U.S. real state.

Adams says the standard property types will continue to be the major components of CMBS pools, as well as some hotels, which investors are understanding better. He adds that it is clear that other exotic property types are not going to be a significant part of he market, and that in 1995 multifamily properties made up approximately one-third of the collateral. That is a significant decrease from the days not long ago when multifamily properties made up nearly 100% of CMBS.

Nonetheless, apartments remain highly coveted and very competitive, says Burke. But "while the sector remains hot today, most major markets are seeing new multifamily construction, which gives us some concern," he says. "We are looking at it a little more closely, but those who buy pools still demand a high percentage of multifamilies." This kind of positive impact that multifamilies have on other loans in a pool is causing some Wall Street firms to be willing to lend to them at a breakeven basis, says Schuster.

REITS show growth potential

While the retail sector dragged down overall REIT performance last year, the public real estate equity market is showing "good solid growth," according to Mark Decker, president of the National Association of Real Estate Investment Trusts (NAREIT), who says "the underperformance of the market is a myth." He points out that some REIT subsectors outperformed the S&P Index last year - health care, hotels, triple net lease, office and self-storage REITs all had a performance record of 25% or better. The NAREIT Equity REIT Index has had an average annual return of 17.2% over the last five years, compared with the S&P's 16.9%. Nomura expects results in the next five years to be similar. In the long term, Decker believes that REITs can offer less volatility than the broader stock market and can provide "good double-digit returns" with less fluctuation.

As for 1996, hotel and manufactured home REITs led the pack in performance in January, and Nomura is particularly bullish on hotel and industrial REITs, and because of "a protracted shake-out in the retail industry," believes that "factory outlet centers will continue to move further into the mainstream of retailing which will benefit current poor pricing."

James E. Kilgallon, who is vice president and director of National Title Services at Commonwealth Land Title Insurance Co. and Transnation Title Insurance Co. (formerly Transamerica Title Insurance Co.), predicts that the top-performing markets will remain on top and may merely change positions. He says hotel and office should remain numbers one and two, and "industrial will continue to move on at its own pace.

Nomura expects initial public offering (IPO) activity to average between $1 billion and $2 billion per year over the next five years, with approximately $1 billion to $1.5 billion of transactions spread between five to 10 noteworthy issues in 1996. Decker says he doubts whether there will ever be another yield-driven IPO frenzy as was seen from 1992 to 1994. "Investors looking for a quick 10% have been replaced by other long-term quality money - the smartest money in the industry. We won't be adding hundreds of companies each year," Decker says. Instead, a lot of growth will come from the existing base of REITs making secondary offerings.

Nomura's Commercial Real Estate Quarterly of January 1996 points out that "REITs represent a very small total of the $3 trillion capitalization of the commercial real estate industry. Of this total, approximately $1.2 trillion is held as equity. Therefore, REITs represent less than 5% of the equity capitalization of real estate. We think this ratio will grow significantly ... as the universe of REITS continues to expand."

Decker says he expects the industry to reach the $100 billion mark in the next year or two and represent $600 billion in 10 years. A capital infusion is expected from small investors, mutual funds and institutional equity such as pension funds and their advisers, who have already begun direct purchasing of REIT shares and have created joint ventures wiht REITs that offer advantages and comfort to both parties.

Decker says it takes time for pension funds and small investors to come around and realize the REIT market is now different and that the gimmicks are gone. "It's the real deal," he says, largely because today's public "real estate company has its value determined not by old-fashioned, one-dimensional property valuation methods but by analysis of management, cashflow and tenancy. In the public market, "real estate becomes more of a management and operating business rather than just a collection of assets," he says. "REITs are a different animal now. They are not just a way to get capital, but personal net worth is at risk."

"REITs provide a more well-capitalized and diversified vehicle for investors that is company-focused and not property-focused," agrees Franzetti. "It is a much more efficient use of capital." Built-in efficiencies come from the public market functioning "as a great policeman" in the allocation of capital, Decker says, which should help prevent REITs from the risk of overbuilding markets again. Scrutinizing analysts would not allow it. "Capital would be priced out of reach," he says.

Decker believes most of the consolidation activity in REITs will occur in 10 years, when the industry is more mature and reaches a $500 billion level. "Not all of the smaller REITs will disappear. Some will grow. As much as investment bankers would love to do M&A (merger and acquisition) activity in t is industry, there are not a lot of companies that are willing and ready to cash in," he says. "Mergers may make sense on paper and generate fees, but the industry is not ready for massive M&A activity as much as is the real estate industry outside of the capital markets."

In other words, the industry may consolidate, with REITs acquiring non-REIT properties. Private real estate companies consist of "a lot of survivors but not a lot of thrivers," Decker says. Those not growing may want to sell assets to healthy REITs. "Larger REITs have access to well-priced capital and don't have to wait for a good market. They can raise debt and equity in any market, approaching it from a blended cost of capital basis, which allows them to successfully bid for properties when others cannot."